September’13 Newsletter: Have We Really Turned The Corner?The Eurozone Recovery? Is It real?

In the two months since we last reported, the media has focussed on the rebound in the EU area, where in the second quarter GDP grew at an annualised rate of 1.1%. The atmosphere has been optimistic, so optimistic, that even the Aug 20 confirmation by Germany’s Finance Minister Schaueble that Greece will default again caused barely a ripple. Even the stock market wobbles over fears of military conflict with Syria were muted (Dow Jones down 4.4% in August). The roundly castigated term "austerity" has appeared only rarely. When it does get a mention it is always used pejoratively, to explain why certain countries continue to have problems. For example, Portugal’s July announcement that it needs to renegotiate its 2011 bailout package is blamed on previously implemented austerity.

Although expressed cautiously, the message conveyed by mainstream media is that Europe is turning a corner and the policies applied have finally started to bear fruits. Is the optimism justified?

The optimism has three sources:

a) GDP and related data: at the start of September, Eurostat reported Euro area and EU27 GDP both up in July, by 0.3% and 0.4% respectively, industrial producer prices up by 0.3%, and the volume of retail trade up by 0.1%.

b) Unemployment: although the proportion of youth unemployment continued to rise, zone-wide unemployment held steady at 12.1% in July.

c) Business Activity. According to data provided by Markit, the Europe wide return to growth in early summer is broad based but small. Spending has increased at both consumer and government levels. Markit’s purchasing managers’ index read 51.5 in August compared to 50.5 in July (50 being neutrality, no growth). This is the most positive data Markit has reported for two years. In particular, Germany’s activity has risen the strongest, while France’s has declined. Italy and Spain have experienced 2 year peaks.

But does this really indicate recovery? If the recovery story had any substance, surely euro futures markets would reflect a material possibility of the ECB raising rates, which they don’t. Perhaps the more balanced reading is that, following such a collapse of capacity utilisation in 2009, there has naturally been a flow of some of the injected liquidity through to manufacturing, triggering marginal increases in production. At these low levels of recovery, the impact is to re-utilise some of the spare capacity and hence unemployment levels have not fallen.

Summary

With interest rates close to zero and central banks purchasing assets with newly created money, words are arguably the most powerful weapons presently in the hands of central bankers, since it is universally appreciated that further interest rate cuts will achieve very little.

By contrast, summer market jitters (see next section) reflected near universal awareness that turning off the QE tap will reveal the bursting of bubbles and systemic banking collapses. Everyone is now firmly fixated on the Federal Reserve’s September 17th policy meeting, and decisions then to be taken as to whether, and if so, how, tapering will be effected.

Presently the Fed purchases about $85.5 bn of Treasury bonds and mortgage backed securities each month. The present view is that the number is likely to be pared to $75 bn, by reducing purchases of Treasuries since these are much shorter term than mortgage-backed securities. Tapering Treasuries would immediately impact the front end of the yield curve, whilst maintaining present levels of mortgage purchases will support the housing market.

The summer news has focused on the subjects of: capital flight, exchange rate movements, and the continuing quest for a new instrument to rescue banks.

July and August saw a series of market panics and sell offs. Capital has been repatriated from the most popular emerging markets as investors, seeking yield, have anticipated rises in dollar-denominated returns when tapering starts.

More generally, the selloff in emerging markets has been both strong and reflective of herdlike, investor mentality. The effect of the selloff is witnessed clearly in currency market movements. For example, the Turkish lira has been hit hard, along with the Indian rupee (down 19% since May 2013) and the Indonesian rupiah (down 13% this year).

One worrying consequence for these regions is that companies are finding it expensive to repay or refinance credit lines, as plunging local currencies drive up the cost of foreign currency debt. Foreign exchange cover ratios (the sum of foreign reserves plus current account balance to short term external debt) are at 7 year lows for the prime Asian sovereign borrrowers also, with India’s cover ratio declining from over 6 to under 2 today.

Investors’ search for yield is unceasing and, in consequence, countries on the fringe of overt support of big currency/ political blocs such as the EU have strengthened. Prime examples are the Hungarian forint (which was the subject of speculative attacks in January) and the Czech koruna. How has sentiment changed!

Other fringe currencies are seeking to ride this popular wave. The Ukrainian central bank makes an active market in domestic Hryvnia against US Dollars, and at the start of September released data showing that, compared to demands to provide $3.4 billion (US Dollars) in the first 7 months of 2012, for the comparable months in 2013 the tide has reversed, and it has faced a demand to redeem $1.8 billion for Hryvnia.

Another summer trend has been the diminishing appeal of bond investment. As rates have remained at near zero levels, investors have lost patience in bonds and have tended to favour stocks. The world’s biggest bond fund, PIMCO’s Total Return fund, has shrunk by 14% since April, a drop of $41bn, owing to investor withdrawals and price falls.

We have previously reported on quirks that the present environment of bankruptcy denial has thrown up, and this summer has seen another. Members of the European Parliament are warming to media support for a new form of proposed contingent convertible debt for banks termed "Equity Recourse Notes". The principal objective of this proposal is to help recapitalise the banks.

An ERN is a debt instrument whose coupon would in stable times be paid in cash, but in times of stress (say, for example, a fall in the bank’s share price of 25% from a fixed starting level) the ERN coupon would convert mandatorily to a payment in equity.

But the proponents of ERNs ignore one important aspect of equity investment: Ownership. A core equity investment right is to have a vote in any future proposals to dilute the equity ownership of the business. This right would be effectively annulled for a bank issuing ERNs.

Take a typical bank whose balance sheet liabilities comprise 10% capital (of which half is pure equity), 40% deposits and 50% debt. If all of the debt were in ERN format, with say a coupon of 5%, and the stress event occurred, the shareholders would be severely diluted within a year. If one year’s coupons were paid in equity, then 5% • 50%, or 2.5% more equity would be issued. The original shareholders held 100% of the equity, representing 5% of the balance sheet. With 2.5% more equity issued they will be diluted by one third.

Therefore, the mere existence of ERNs in the market would crush the market for conventional equity for banks.

Furthermore, a trigger based on share price movements is a poor indicator of stress. The share prices of the UK’s failed banks are roughly 10% of where they were pre-crash, ignoring the actual infusions of bailout cash. A 25% variance in the sprint speed of a snail is a meaningless and gameable definition of stress.

History demonstrates, unsurprisingly, that when investors have concerns about solvency they want a cash option, not to be forced to take equity in a failing business. ERNs are nothing more than the latest chocolate teapot solution to the problem of failing banks.